Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar fund analysts Ryan Leggio and Kevin McDevitt recently visited with Bruce Berkowitz of the Fairholme Fund in his Florida offices. They brought back some interesting insights about the St. Joe holding, which has been in the news a lot, as well as the operations of the Fairholme Fund, in addition some insights on the new Allocation Fund. Ryan Leggio is here to share those with me today.

Thanks for joining me, Ryan.

Ryan Leggio: Thanks for having me, Jason.

Stipp: So first question for you: St. Joe has been, obviously, the biggest newsmaking holding of the Fairholme Fund. A few readers have asked us, the way that Bruce Berkowitz and the Fairholme Fund has been involved with this company, it reminds them a little bit of maybe Warren Buffett and Berkshire Hathaway way back in the day, and maybe St. Joe will be Bruce Berkowitz's Berkshire Hathaway. Does he have plans to transform this into some sort of an investment vehicle down the road?

Leggio: Well, we specifically asked him that question when we were at his offices in Miami. Certainly, it is a very high-profile, activist type investment for the most part, and in Bruce Berkowitz's decade-plus at Fairholme, he's taken a passive investment approach to most of his holdings, and specifically, he said, he doesn't have an interest in taking over St. Joe and making it private, and specifically he said this:

Bruce Berkowitz: We would be happy to step off the board; that's not the business we're in. But if it's going to be valuable to our shareholders and to the shareholders of St. Joe, then we'll stay. It depends also to what extent what St. Joe becomes. I'm pretty optimistic, I know the worst case, and the worst case is going to work out reasonably well for shareholders. The question is what's the best case? And could it be something that no one has even dreamt about before?

Stipp: So Ryan, it sounds like Berkowitz's very hands-on involvement with St. Joe is really to make it the best investment that it could be for the Fairholme shareholders. But I have to ask: This is a relatively small position in the Fairholme Fund, especially compared to all the news that it's been making recently. Is it too much time that he's spending on such a small stake?

Leggio: I think that's a great question, and certainly, a lot of our readers have asked us about that. I think there would be two points about that. One, it is a small position size for the Fairholme Fund right now, but that doesn't mean it will be in the future.

One of things he accomplished with this board fight, and replacing the board of directors, is removing the poison pill provision that was in place, which limited him from increasing his size in St. Joe. So, I wouldn't be surprised if in the next few portfolio holdings, we actually see a much bigger stake in St. Joe.

I think the second thing which you also have to remember is, this really hasn't taken all that much time. It's been in the news for a couple of weeks, and the good thing about it is it's really probably unlocked some value with Joe; instead of the old plan of burning through money and going through losses, now this new operational structure is going to be mean and lean in Bruce Berkowitz's words. So, it probably has increased the value of St. Joe.

Stipp: So speaking of the operations of the Fairholme Fund and how they look into securities and the size of the fund now. There's some interesting insight that you gleaned about the operations of the fund, and it's a lot different than a lot of other funds you cover as far as their day-to-day work. Can you give us a little bit of a picture inside of the Fairholme Fund and how it works?

Leggio: Sure. So, at their offices, it's one floor of a large office building in Miami. He has dozens of support personnel. Interestingly, though, as far as true investment analysts, it's mainly Bruce Berkowitz and Charlie Fernandez, the president and co-portfolio manager, and four analysts, who don't really do investment type of analysis, but really do the legwork on work that Bruce and Charlie need them to do, whether it's spreadsheets or pulling public files on holdings, etc.

So all of the real analytical strength, then, is from this outsourcing model, which is really unique in the fund industry, where he hires consultants depending on the types of investments that look interesting to him. He says it's because he wants to be a manager of investments, not people, and specifically when we asked him about it, he said this was the reason why he decided upon that model:

Bruce Berkowitz: If you look through our firm, there will be times when you will see the firm grow to, it would seem, like there's a 100 people, because we may have 30 people on a legal team here, a forensic accounting team there, analysis there, which were all pricing, valuation group there. They are all professionals, where they are called consultants, vendors, whatever you want to do, but they're working for us; we use them. We go into turbo mode in the area we need to, and when we're done, we can pull back.

Stipp: So it certainly sounds like a very distinctive and also a very flexible model, but not just any fund could really undertake operations in this way, right?

Leggio: I think that's right, and a great example of that was one of the consults he brought in, who is still working for him, a very senior legal partner at a law firm in New York. These are the law firms that charge between $500 and $800 an hour. He helped him on the MBIA transaction, helping him on other legal transactions right now.

He told us, currently, they have 14 active consultants, kind of same level of seniority and expertise and payroll for that matter, spending about 50% of their time exclusively on Fairholme-related analysis work, and there are people all over the country. So, there were people out at St. Joe looking at those property records. He has a retired legal partner looking at every single MBIA filing that comes out of the court. So, very, very distinctive model, high levels of expertise, and for him, I think, he thinks it really adds an informational advantage to the Fairholme Fund.

Stipp: So, really instead of having a whole group of full-time analysts that work just for Fairholme and that are covering areas where there is no investment opportunity, he's instead very targeted with that model. But I think also the fact that he runs a concentrated portfolio probably enables this to come about in a more efficient way than at a fund that has hundreds of holdings, for example.

Leggio: I think that's right. Where he really only has to have a few experts for particular holdings. He doesn't have to have a financial analyst around on payroll, twiddling his thumbs, when he didn't see any financial holdings worth buying in 2006 and 2007. So, a very flexible model, and definitely a unique one in the industry.

Stipp: So, the third major thing that you talked about with Berkowitz was the new Allocation Fund. So, this is a fund where there is not a lot of public information about the holdings yet, but he did tell you a little bit about how the fund might be run and what kind of stakes it might take. Can you give us some insights there?

Leggio: Absolutely. You're right. There are no public filings yet, but he gave us some indications on what the fund is going to look like going forward. I think, the first thing, you'll notice is, it's going to be very concentrated, similar to the Fairholme Fund, but possibly even more concentrated.

The example he gave there was MBIA, where the Fairholme Fund owns roughly 10% of the company, but it makes up less than 2% of the assets of Fairholme. Well, in this new fund, which is only just started, couple of $100 million in assets, a 10% position in MBIA could be 10% position in the new Allocation Fund. So, look for it to be very concentrated.

I think, the second thing, which a lot of people have thought about which is true, is that smaller opportunities, smaller cap, mid-cap names, which really won't move the needle in Fairholme now that it's so large, will probably populate the Allocation Fund at least initially.

The third thing is, even though it's called the Fairholme Allocation Fund, don't expect it to be this middle-of-the-road balanced fund between opportunities in Fairholme and Fairholme Focused Income. He's made it pretty clear he's going to be very dynamic, willing to go very little cash when he sees lots of opportunities, lots of cash when he isn't seeing opportunities. So, look for it to be a very dynamic and unique offering.

Stipp: So, it's great to have a nimble fund in the hands of a very accomplished manager. How long do you think it's going to stay nimble, though?

Leggio: Well, it's tough to tell. The Fairholme Focused Income Fund, which is a little over a year old, is now almost close to $1 billion in his hands. So, if investors like the new portfolio, then I suspect it's going to get large very quickly. But we specifically asked him about that as well, and he says he's cognizant of the size, wants to keep that fund nimble, and will close it when the opportunity set no longer matches the fund size.

Stipp: All right, Ryan. Thanks for coming back with those great insights and for joining me today.